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CME Does Well, Thinks Big

The Chicago Mercantile Exchange has ambitious future plans.

CBOT Holdings' (NYSE:BOT) stellar quarterly earnings report last week set the bar a little too high for rival Chicago Mercantile Exchange Holdings(NYSE:CME), which nevertheless posted a solid second quarter.

Yesterday morning, CME announced earnings of $3.12 per diluted share. The 32% year-over-year increase topped analysts' consensus estimate of $3.09. Let's look at some of the drivers behind this result. (All percentage changes refer to a year-on-year comparison.)

Net revenues increased 23% to $295 million. More than two-thirds of those revenues were clearing fees and transaction fees that CME assesses from those who transact on the exchange. These fee revenues rose 25%, thanks to record quarterly average daily volumes across all product categories; average daily trading volume increased 40%. However, volume discounts and a higher proportion of member firm volume contributed to a lower average rate per contract -- $0.632, versus $0.651 for the year-ago period.

Consistent with its "tollkeeper" business model, CME has phenomenal operating leverage. You can quantify this via incremental operating margin, defined as the increase in operating income divided by the increase in revenues. Year over year, CME's incremental operating margin was 78% -- when it rains, it pours!

CME is pursuing future growth in several ways. In the near term, it's adding functionality to the electronic trading of Eurodollar options, since Eurodollar futures and options are CME's flagship contracts.

More audaciously, CME is working to bring products traditionally traded over the counter into the fold. During the second quarter, CME joined with Reuters(NASDAQ:RTRSY) to create FXMarketSpace, a centrally cleared foreign-exchange trading platform. Existing electronic foreign-exchange marketplaces have already had some success, most notably State Street's (NYSE:STT) FX Connect. Still, the combination of anonymity and a central clearing mechanism could prove to be a powerful differentiator for FXMarketSpace, and with six of the seven largest foreign exchange-dealing banks signing on, liquidity won't be an issue. The service is set to launch in early 2007.

Earlier this month, CME announced its acquisition of Swapstream, an electronic trading platform for euro- and Swiss franc-denominated interest-rate swaps. With a daily turnover of $550 billion in notional value, the swap market is large and mature. Capturing part of the shift from voice transactions to electronic trading could be lucrative, but the $550 billion question is how rapidly that shift will occur. For now, Swapstream's cost run rate will total approximately $3 million per quarter, with breakeven expected in 2008.

CME's growth strategy is more ambitious, but it's also riskier than that of CBOT, which is focused on building volume in more traditional exchange-traded products. Nonetheless, both companies are great businesses. For investors thinking about purchasing CME shares, the principal risk relates to valuation. You get some sense of the growth assumptions baked into CME's current price when a 32% year-over-year increase in earnings per share is rewarded with a near 3% decline in the shares relative to the S&P 500 (based on Tuesday's closing prices). Caveat emptor!